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Advocacy Article

Effective Federal Income Tax Rates Faced By Small Businesses in the United States

Federal, state and local taxes represent a major cost of doing business in the United States, and this is particularly true for small businesses. The array of federal taxes that small businesses face includes income taxes (individual and corporate), social security and Medicare employment taxes, excise taxes, and unemployment compensation taxes.

Under the federal income tax system, a progressive statutory rate structure applies to income of businesses and individuals. The income of corporations is taxed twice, once at the corporate level through the payment of the corporate income tax, and again at the individual owner (level) of a corporation when corporate profits are distributed in the form of dividends or capital gains. Other forms of business, such as sole proprietorships, partnerships, S corporations, and limited liability companies, are not subject to an entity level tax, and business profits are taxed only at the individual owner level.

Calculating the overall costs of federal income taxes to small business owners requires an examination of both corporate and individual income taxes to explore who bears the burden of the taxes on business income. The federal income tax system is progressive, meaning that the tax rate increases as income increases and ranges from 10 percent to 35 percent under current law. In addition, exceptions to the normal tax rules (e.g., deductions, exclusions, and credits) can have the effect of lowering the overall tax rate actually imposed to a rate that is less than the statutory rate. Thus, there is a difference between the statutory tax rate imposed on business income and the effective tax rates that the small business (and its owners) may face. Effective tax rates provide a more accurate picture of how taxes are imposed on small business owners than statutory tax rates.

This research attempts to calculate the average effective tax rates faced by small businesses as a result of federal income taxes. The research explores how these effective tax rates vary depending upon the form of doing business (e.g., sole proprietorship, partnership, corporation, etc.), industrial classification, and business size. The research also examines the impact of special provisions in the federal tax laws that apply only to small businesses.

The primary methodological approach employed for purposes of this study is a microsimulation model in which aggregate (macro) outcomes are simulated “from the bottom up” by calculating tax liabilities at the entity level. This modeling framework is supported by use of the Public Use Statistics of Income (SOI) microdata file prepared annually by the Internal Revenue Service. The SOI data files are augmented with statistical imputations to trace the ultimate tax burden with respect to pass-through entities that do not pay federal income taxes directly.

The research detailed in this paper is limited to the effective tax rates imposed on small businesses by federal income taxes, due to the complexity of the analysis required for this study. This research could be extended to explore the effect of other federal taxes, such as federal estate taxes, excise taxes, employment taxes, and state and local government taxes to provide a better picture of the overall effect of taxes on small business in the United States.

To view the research summary and the full report of this study, please see the attachments below.